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Aftershock?

In between picking out books about crazy cats, dragons, and big sisters for my two 2-yr old daughter at the library last weekend, I decided to grab “Aftershock” (2nd edition) by David Wiedemer and give it a quick power read. For those of you unfamiliar with the book, “Aftershock” is the follow up from the authors of a book that presciently predicted the 2008/2009 housing and stock market crash. Like the sequel to Saw they ratchet up the fear mongering and paint a very ugly picture regarding an even larger looming crash encompassing real estate, stocks, government debt, and the dollar in light of the Federal Reserve’s easy money policy over the last few years. While their predictions regarding real estate, the U.S. dollar, and stocks have been dead wrong so far (i.e. S&P up 16% annually since 2011) they adamantly maintain on their website that their theories are sound and that sometime between 2014-2016 the Aftershock will be upon us. Their thesis is partially based on the following statistics:

U.S. house prices almost doubled from 2001-2006 while real household incomes increased 2% over the same period. In theory, housing prices should track with homeowner’s ability to afford them.

Rapid improvement in the stock market has had no bearing on earning or GDP growth, but rather easy money policies by the Fed. Over time, the market can only rise relative to GDP and earnings growth. To support their concern they site that the Dow rose fourteen-fold from 1982-2007 despite company earnings growing only three-fold over the same period.

The U.S. annual deficit has increased by almost 550% from $250 billion in 2007 to $1.6 trillion today. Overall U.S debt has increased from $8.5 trillion in 2006 to over $16 trillion today.

The U.S. money supply increased 200% over four years ($800 billion in 2008 to more than $2.4 billion in 2011) with virtually no inflation-effect to date.

They continue to argue that artificially-inflated markets in light of the conditions above will face a major reckoning once inflation kicks in and interest rates rise significantly. Consumer spending plummets, low rate debt will be refinanced with painful high rate debt, homeowner purchasing power will go down the tubes along with real asset values, the purchasing power of the dollar will significantly weaken, you get the picture… Their investment solution for this scenario is as follows:

Buy gold or silver!

Buy American-made commodities like coal

Invest in TIPS (inflation-protected government securities)

Invest in foreign currencies less susceptible to monetary easing policies

Sell all of your real estate!

I’m not writing this post with the intent of endorsing the “Aftershock” assertions or trying to scare the common investor. Personally I’m a little nervous about pricing levels in the stock market, real estate prices, and scared to death of the bond market. Overall P/E ratios are above historical norms despite a disappointing earnings season and record low interest rates are temporarily propping up property values while U.S. employment and GDP growth slowly inch upwards at an uninspiring pace.

Despite this, people still go on living their lives, owning homes, consuming goods, creating new ideas and products, and responding as best they can to the conditions around them. This is why I believe that while one needs to pay attention to the macro conditions around them and pay particular attention to the value metrics of any investment, there will continue to be great investing opportunities in the stock market. We could very well experience a material drop in the markets (10-20%) and I think everyone is accepting the eventual reality of higher rates, but I’m not too worried about the doomsday scenario- despite its problems the United States is by far the most diversified, robust economy in the world. Don’t fool yourself in thinking you are smarter than everyone else, however- DIVERSIFY your portfolio into areas like international markets, real estate, gold/ silver, commodities, TIPS, private equity, etc. just in case your world view of the future doesn’t pan out exactly how you or I think it will.

The purpose of this blog is not to educate people on diversification- we’re stock pickers at heart. (A perfect example of this is that one of my potential investment “solutions” to the Aftershock theory is to implement a market neutral investing strategy, offsetting long and short positions for companies within the same industry and trusting your stock-picking prowess to garner returns.)

If you want to learn more about diversification and how the big boys do it, I recommend the book “Pioneering Portfolio Management” by David Swenson, long-time CIO of the Yale Endowment fund. This is generally regarded as the magnum opus on endowment investing and how to achieve superior risk-adjusted returns through thoughtful asset allocation across various investment classes.